Wednesday, September 26, 2012

Where Are The Bears?

Note: Market notes and leading economic data will not be not updated in this post. Since I am specifically updating equity sentiment in-depth, there is no real need to update other matters until the next post. Nothing dramatic will change from today until later on in the week.

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It has now been about a year since I did a major sentiment post on the equity market. Back in late September and early October of 2011, I was insisting that if I had to choose between equities, bonds or cash - I would have chosen to buy equities. While there was the possibility of a recession, personally I remained in the camp that we would not experience negative GDP quarters until later on in the cycle. It is very important to remember that back in late September 2011, market conditions were one of forced liquidation, very elevated volatility; extremely negative sentiment surveys; large hedge funds losses; very high levels of institutional cash; extreme put buying; total panic in fund outflows and finally corporate insiders who are considered to be smart money were scooping up bargains at the fastest pace since the March 2009 bottom.
Nothing stays the same for a long period of time and just as everything in life always changes, so do market conditions. It is amazing what a year can do. Fast forward to September of 2012 and the US equity market was recently up 30% on annualised basis, as we can see from the chart below. If you think that is quite an amazing performance within a 12 month period - mind you on the back of global economic deterioration - you should have a sneak peak at the German DAX 30. Within just 12 months, the DAX 30 has managed to rally from below 5,000 towards almost 7,500 - an astonishing 50% gain. The DAX 30 has only ever performed better coming out of a recession or during the stock mania of the late 1990s.

Both of these charts now signal that we are most likely at an intermediate top of some kind. Keep in mind that strong performance coming out of a recession, seen in 2003 and 2009, is quite normal post a major bear market. Having said that, when the bull market ages towards its 3rd or even 4th year, powerful performance like the one we have witnessed over the last 12 months - while fundamentals deteriorate - is more closely linked to speculation and signal that a more significant top could be in place. Away from the performance indicators, let me put forward a write up which paints the completely opposite picture to the one we saw in September and October of 2011.

Volatility: The VIX measures the implied volatility of near term at the money S&P 500 options. VIX will typically rise when the market drops and fall when the market rises, and while this is not always the case the correlation is clear. High volatility signals a capitulation bottom is in place, while low volatility is associated with complacency (especially during deteriorating fundamentals). Currently the VIX has been trading within the "danger zone" for several months. Recent readings have managed to close at the lowest levels since the 2007 market top and more importantly the VIX's 200 day moving average has edged down to a "17" handle, which is the lowest long term average since the 2011 market top. As already discussed before, central banks have intervened to suppress volatility... for the time being.
Now... I know what some of you bulls are thinking. You will argue that the VIX could stay at low levels for a prolonged period of time. That is fair enough. However, one should never argue any point without first understanding the underlying conditions and context. Here are two points that state why I personally believe the VIX will not yet trace out a period of low volatility like we saw in 2003-07:
  1. Fundamentally, underlying conditions in 2003-07 were one of a global economic boom including BRICs, rapid credit growth, global housing and a commodity boom. Today, the global conditions are experiencing a huge amount of headwinds (which we have covered on this blog a million times) and as long as these issues remain unresolved every "band-aid" fix from governments and central banks will eventually fail and the volatility (fear) will spike again and again.

  2. Technically, if the VIX was to remain at low levels for an extended period of time, it won't do so after a market rally of 120% (S&P from March 09), but rather the VIX tends to fall at the beginning of a bull market and flatlines for years. Notice how in early 2003, just as the bull market started, the volatility died down (due to strong fundamentals) and remained quiet for years? In my opinion, it is ridiculous to think that the VIX will further calm near a peak of an aged bull market instead of at its birth, like we saw in 2003.
Sentiment Surveys: The Investor Intelligence sentiment survey is conducted weekly and the bearish reading of the survey is one of the indicators I give most attention. The survey is based on 140 advisors aka "market pros" and their stance on the market, which can be either bullish, bearish or neutral. While this indicator signalled extreme bearish readings in September 2011, since the beginning of 2012 the bearish readings have remained very low. High levels of bearish sentiment is usually needed for the markets to rise higher, as it indicates the majority of participants are not invested. This is usually known as a "wall of worry".
Today, the sentiment picture is far away from a "wall of worry" rather one of comfort and complacency. Consider that even during the 10% correction in May, bearish sentiment did not rise, which indicates that we never really saw a true capitulation of fear at the last intermediate bottom around 1,266 on the 1st of June.  Relatively low bearish sentiment readings for a prolonged period, usually signal that the market is close to some type of a significant top, rather then a bottom. Similar occurrences were witnessed during late 2006 through early 2007, late 2009 through early 2010 and late 2010 through to early 2011 (chart above). All of them led to meaningful corrections in the coming months.
Staying with the topic of extremely low bearish sentiment, the chart above paints a similar picture. The National Association of American Investment Managers (NAAIM) tracks active fund manager's exposure within the market place. We can see that, instead of paying close attention to the range of exposure, I find it is much more important to track the length of time where manager's beliefs become crystallised towards a certain trend. The chart clearly shows that periods of prolonged bullish belief without any bears, tends to lead to significant under-performance for the equity market. Since we aren't just coming out of a recession like in late 2009, the current lack of bearish sentiment in an aged bull market signals we are much closer to a top.
Various other sentiment surveys are all flashing warning signals. The chart above, thanks to Elliot Wave International, shows that retail investors are now "all aboard" the market rally. Bullish sentiment readings are now at the highest level since the market top in 2007. Other sentiment indicators worth paying attention to:
  • Consensus Bullish % Index currently stands at 72% bulls. While the sentiment was slightly higher at 78% bulls in March of 2012 prior to the market selling off 10% into May, it is important to realise that the readings are highly elevated from the October 2011 low, when we saw only 27% bulls. This is definitely a warning signal from a contrarian point of view.
  • The Hulbert Stock Sentiment shows readings of +53%. That means "market pros" are now recommending their clients to be +53% net long, while exposure for the higher beta Nasdaq is even higher at +65%. Consider that only a few months ago during the May sell off, advisors recommended -20% net short exposure. We've come a long way in a short period of time.
Cash Levels: If you listen to all the market gurus, experts and analysts on CNBC or Bloomberg, you get the impression that hardly anyone is invested in the current bull market. If that is true, how the hell  did the market climb from 666 on the 6th of March 2009 all the way to 1465 in recent days? Someone had to buy it right, otherwise it wouldn't have risen. And it takes cash to push the price of any asset, including the stock market, to higher levels. Basically, that's just common sense. However, the current buzz words seem to be that "there is a lot of cash sitting on the sidelines" or an even better one that "there is abundance of liquidity around" and finally a Pavlov's dogs favourite is that "you shouldn't short the market because central banks will support it".

If all of these phrases sound awfully familiar to you, that is because you probably heard them being thrown left, right and centre by market "pros" from CNBC at the previous market tops in 2007 or 2011. I was reading Marc Faber's February 2007 newsletter the other day and this is what I came across:
"The last point I should like to make about the widely used buzzword “excess liquidity” is the following. Did anyone hear about “excess liquidity” at the markets’ lows in October 2002, and last June after just a modest correction? 
But I have heard the words of “there is just too much money around”, “the market will never decline because foreigners will continue to buy”, “should the market decline the government will support it”, “plenty of liquidity will drive prices higher” in Japan in the late 1980s, in the Asian emerging markets just ahead of the crisis in 1997, and in the midst of the NASDAQ bubble. Words like “excess liquidity” and “record corporate profits” are more closely associated with important market tops than with market lows!" ~ Marc Faber
I searched and searched and then searched some more, but I found it hard to find any real data that supports the fact that "there is plenty of cash on the sidelines." Instead, I found the opposite. The chart above shows the monthly survey by AAII in regards to their portfolio allocation. Participants  have a choice of either stocks, bonds or cash. As the chart shows, currently cash levels are extremely low at 18%. Cash levels above 25% tend to signal a minor buying opportunity, while cash levels towards 35% tend to signal a major buying opportunity. Furthermore, cash levels are also very low in the following indicators:
If there was plenty of cash on the sidelines, it would show somewhere, somehow - that is for sure. All of the links above show that, be it mutual funds, money market funds or hedge / pension funds, one thing is for certain - cash levels range from low, complacent readings to dangerously low levels in some cases.

Fund Positioning: Another myth in the market place currently circulating around (usually heard a lot near market peaks) is that funds are currently underinvested or underexposed to the current market rally. According to the latest CFTC Commitment of Traders report, hedge funds and other large speculators are extremely net long high beta technology shares, which tends to be a great proxy for the overall market (chart below). 
Furthermore, the recent NYSE Margin Debt report while not as high as 2007 market peak, showed that leveraging and gearing levels for funds is quite high. If funds weren't participating or being exposed to the rally, why is the margin debt so high?

The recent Merrill Lynch Hedge Fund Monitor report showed that the estimated net holdings for hedge funds remains very elevated, even after the June correction (chart below). Since the chart above is outdated and we know that the market shot straight up in August and September, we can imagine that hedge fund exposure could now be extremely high or even close to record levels. Merrill Lynch also shows that the exposure to cyclical sectors is also very elevated.

I find that very puzzling because cyclical sectors have under-performed the overall market by a wide margin since early 2011. In that regard, it seems that hedge fund managers are still in denial when it comes to falling corporate earnings, a weakening manufacturing cycle and overall deteriorating economic fundamentals. A classic mistake is to continue to remain heavily exposed to an asset class even after it tops and starts sliding down the slope of hope.
Corporate Activity: Gary Kaminsky of CNBC was on last night (Asian time) trying to convince the viewers that while mutual fund outflows continue to signal that retail investors are not participating in the recent rally, the really bullish signal was the very high level of Corporate Buybacks. I personally didn't really listen to the whole presentation, but straight away it should be obvious to anyone that high levels of Corporate Buybacks are not a buy signal. Quite to the contrary, they tend to be a contrarian sell signal.
The same data is presented in the chart above, thanks to JP Morgran's recent newsletter (shout out to a friend from Paris). I've quickly overlapped the S&P 500 with the Corporate Buyback data, so one can easily understand that this is much more of a contrarian signal than anything else.  The green line, which is a 6 month moving average, shows that elevated levels of Corporate Buybacks tend to occur near major market tops (2007 and 2011), while depressed levels of Buybacks tend to occur near major market bottom (2009). While the chart is slightly outdated, I could assume as prices rallied higher into September and the so called Draghi / Bernanke Puts have been announced, corporate buybacks probably soared.
What I find very interesting is the fact that Corporate Directors have bought the 8th highest amount of shares in dollar terms during June of this year, while at the same time these same Corporate Directors are heavy sellers of stocks from the recent report (chart thanks to Technical Take blog). Does anyone find that amazing? Here we have Directors ordering high Buybacks to push share prices to elevated levels and at the same time, these same guys are selling their own stock holdings for very handsome profit, which has been benefited by Buybacks. I don't know if this is making you scratch your head or not, but pretty much we have a bunch of "crooks" running the show these days. Regardless, from
"Insider selling levels remain moderately high heading into the end of Q3'12. From a historic perspective the volume of activity has not been particularly egregious, however, the selling has been persistent throughout the quarter and sellers have shown far more conviction (e.g. more Sell Inflections than Buy Inflections, Cluster Sales than Cluster Buys, etc.) than buyers on a macro and company level."
Consumer Confidence: The University of Michigan Consumer Sentiment readings came in close to 4 year highs earlier this month. At the same time, the stock market is also at four year highs. Year on year change in Consumer Confidence has been one of the biggest on record, and while that tends to be positive coming out of a recession, public optimism is never a good signal for an aged bull market.
Another major warning signal is that more affluent and wealthier Consumers are much more confident relative to those with smaller net incomes. Why is this so important? These individuals are much more likely to have exposure to equities and other risk assets (corporate bond / real estate etc). Consider that these individuals were very optimistic in late 2006 and early 2007, just prior to a market top; and at the same time very pessimistic in early 2009 as the market crashed. Their current confidence level, mainly thanks to Helicopter Ben Bernanke, has them thinking that it is impossible for the stock market to decline. From a contrarian point of view, this is a major negative.
Summary: While a year ago, we had panic and fear rule the market, the current market conditions have me wondering where are all the bears? Weather we look at the remarkable performance of S&P 500 or DAX 30, extremely complacent levels of volatility, overly optimistic sentiment surveys, very low levels of cash, high risk exposure by hedge funds, the high level of corporate buybacks mixed together with a high level of insider selling or the elevated consumer confidence relative to last year - they all tend to send a signal that the market seems to be forming a more meaningful top around the current levels. Furthermore, while this post is not about fundamental analysis, let us not forget that we are now very late in the business cycle and a recession is most likely around the corner (chart below).
Finally, if there is one major indicator to sign of excessive speculation and overwhelming bullishness within the market environment, then it has to be the darling of the stock maker itself - the Apple parabolic. In his July 2012 newsletter, Marc Faber quotes Mr Newman on the following about Apple:
“ the three months from the beginning of March to the end of May, transaction in AAPL comprised one of every $16 traded in the U.S. market, very likely the most concentrated focus on one stock in the stock market history. The dollar trading volume in just this one issue equated to $23 of GDP, or all business transacted for the entire country during the three months period.”
Trading Diary (Last update 05th of September 12)
  • Long Positioning: Long focus is towards the secular commodity bull market, with positions in Precious Metals and Agriculture. The largest commodity position is held in Silver, due to central banks gearing to print money, as the global economic activity deteriorates. If a negative reversal occurs and global risk asset volatility rises, reducing positions will be appropriate. NAV long exposure is about 100%.
  • Short Positioning: Short focus is towards the secular equity bear market due to deteriorating global economic activity. Exposure is held short in Junk Bonds, Technology, Discretionary and Dow Transportation. Tech stocks like the Apple parabolic and Amazon have been shorted with long dated OTM puts. Put options have also been purchased on the Pound and the Loonie (long USD). NAV short exposure is about 70%.
  • Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in a midst of a huge bubble mania. While Grains have exploded up, Softs still present amazing value for long term investors, with Sugar being my second favourite commodity (after Silver). Japanese equities are down about 80% from their all time high over two decades ago and offer some great value.
What I Am Watching